Inflation Ahead? High Yield Sectors and TIPS Offer Best Returns

Feb. 2.11 | About: iShares TIPS (TIP)
It seems the market is finally coming to terms with the idea that we might go into a period of rising inflation in the future. The U.S. economy is currently undergoing a some sort of a stabilization phase. If this economic stabilization continues in the U.S., the increased money supply we have seen over the last few years can create a highly inflationary environment in the future. In fact, emerging markets are already experiencing a higher inflation environment with asset bubbles being created.

Why is the 1972-1982 era suited to study the current inflation environment?

The U.S. economy went through a period of high inflation during 1972-1982, due to the OPEC oil embargo and the Iranian revolution. I believe a closer study of the performance of different asset classes during the 1972-1982 period can help us identify a suitable investment strategy for a possible future environment of high inflation.

In 1972-1982, inflation was created by higher commodity prices. We are currently in the middle of the making of a commodity bubble as well.

Chart-1: High U.S. Inflation during 1972-1982

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Click to enlarge

High inflation - An investor's nightmare

For the purposes of this study, I have broken down the performance of the equity markets and the Treasury bond market into three broader time ranges. Namely, the “pre 1972”, “1972-1982” and “post 1982” periods.

Table 1 below summarizes the performance of the equity and Treasury markets. Clearly the equity market didn't perform well during this period and bond yields expanded- as you would expect under a high inflation environment. But once you adjust for the 9% average inflation, bond investors didn't make much in real returns either.

This leaves us with the other major asset class; commodities (or more specifically gold and other precious metals). Despite it sounding very logical to invest in gold, the mere fact that it has become such a crowded trade makes me think that there is a bubble in the commodity market. Therefore in this article I will avoid discussing gold.

Table-1: Inflation creates a difficult environment

Period
51 -72
72-82
Post 82
Avg. inflation
2%
9%

3%

Avg. equity return (annual)

8%

-1%
9%
10 yr gvt bond yield
5%
9%
7%
S&P volatility (S.D)
12%
16%
16%
Sharp ratio
0.2
- 0.6
0.1
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Which sectors are immune to high inflation? None

In trying to find out the value within the equity market, I have studied the different sector level performances in table 2 below. The only historical sector level data series that I could find started from 1973, so I haven’t studied the sector level performances prior to 1972. By looking at the simple price performances of different sectors, it seems that none of the sectors have added any positive returns to investors’ portfolio during this period.

Table-2: Equity market, simple price return

Returns (annual)

Abs. Return

Rel. Return
Sector
72-82
Post 82
72-82
Post 82
S&P
-0.6%
8.9%
0.0%
0.0%
Consumer Staples
-0.7%
12.3%
-0.1%
3.3%
Cons. Disc.
-4.4%
10.3%
-3.8%
1.4%
Financials
-0.6%
9.7%
0.0%
0.8%
Health Care
-0.8%
11.6%
-0.2%

2.7%

Industrials
0.0%
10.8%
0.6%
1.9%
Telecom, Media, IT
-2.8%
9.1%
-2.2%
0.2%
Telecom
-0.4%
5.9%
0.2%
-3.0%
Utilities
-2.6%
5.0%
-2.0%
-3.9%
Click to enlarge

What about the Dividend? Not 100% immune, but provides a better option

I have done the same analysis I did above using the total return (i.e. capital gain + dividend) on a sector basis. The results are more promising. Normally higher dividend-yielding sectors did provide some form of comfort to the investor. Both Telecom and Utility sectors comfortably outperformed the broader market index. So it seems an investment strategy focusing around high yielding stocks/sectors should provide some form of comfort to an investor.

But when you consider the average inflation rate of 9% that the U.S. market experienced during the 1972-1982 period, the 7.6% return out of the telecom sector is not very promising. Investors would have still lost 1.4% per annum of the real investment.

Table-3: Total return by sector

Returns (annual)
Abs. Return
Rel. Return
Sector
72-82
Post 82
72-82
Post 82
S&P
3%
13%
0%
0%
Consumer Staples
3%
15%
0%
2%
Cons. Disc.
0%
12%
-3%
0%
Financials
4%
13%
1%
0%
Health Care
3%
14%
-1%
1%
Industrials
4%
13%
1%
0%
Telecom, Media, IT
2%
11%
-1%
-1%
Telecom
7.6%

10%

4%
-2%
Utilities
6.5%
11%
3%

-2%

Click to enlarge

What about TIPS?

TIPS naturally provides a hedge against inflation. By looking at the chart given below, it seems longer duration TIPS are still providing reasonable returns. Another advantage of TIPS is that they are generally less volatile compared to equity investments. The main concern I have with TIPS is the possibility of the U.S. Treasury ratings getting downgraded due to deteriorating U.S. governments’ fiscal position. But given the position enjoyed by the USD as the reserve currency, I don’t think this is going to materialize in the near future.

Chart-2: TIPS yield : Investors already pilling into TIPS

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Chart-2: TIPS yield: long term TIPS are providing good valueClick to enlarge


In my view, an investment portfolio consisting of high yielding sectors such as utilities & telcos as well as inflation-hedged TIPS should provide the best investment return for investors should there be an increasing inflation environment in the U.S.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.